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“Why get out of bed and go to work if you’re only gettin’ paid $4 million in stock options?” 
An Analysis of Executive Compensation
By Gabriel Lopez and Michael Ross“A gorgeous woman slinks up to a CEO at a party and through moist lips purrs, ‘I’ll doanything
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anything 
 
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you want. Just tell me what you would like.’ With no hesitation, hereplies, ‘Reprice my options.’” (Buffet, 2002). Warren Buffet used this joke in his 2001 annualreport to illustrate the excessive greed involved in executive compensation. Currently, corporate boards across America liberally grant enormous stock option packages to their CEOs. In 2000,the average CEO earned over 531 times the average hourly worker. In 1990, the average CEOearned only 85 times as much (Reh). While many critics argue that such compensation packagesare grossly excessive and downright unethical, the executives who earn them see no problem. Itis often argued that if executives earn what they are paid, then there is no ethical problem withsuch a high salary. The question then becomes: Are they actually earning what they are being paid? The following, we believe, are justifications CEOs would offer in explanation of their pay.We will address each of these justifications and ultimately demonstrate that there is no certaintythat their compensations are justified. While we cannot prove whether or not executivecompensation is excessive, we believe that absent the market efficiency barriers described below,the pay packages CEOs receive would be substantially smaller. In short, we believe marketinefficiencies leading to high transaction costs result in excessive executive compensations.
Justification #1:
 A good CEO creates value greater than his compensation.
 
A typical CEO will argue that a large compensation package is justified because hecreates a large amount of value for the firm. Surely it is ethical to accept such a large amount of options because without that CEO, the firm would not be nearly as valuable. But how is the1
 
value created by a CEO calculated? Can a CEO really take credit for value creation in such alarge corporation with thousands of employees? Let us take for example the value created by a professional baseball player, like Barry Bonds. Barry hits lots of home runs, which helps histeam win games. Fans pay money for tickets to see Barry, which creates value for the franchise.If Barry strikes out more and hits fewer home runs, then his team will likely lose more gamesand fewer fans would pay for tickets. It is clear that Barry is compensated for the value hecreates for his team. If Barry thinks he is underpaid, then he can seek employment with another team. If Barry performs below expectations, then his team will reduce his pay or trade him toanother team. However, the situation of a high-paid CEO is much more complex. Unlike baseball, corporations have thousands of contributing team members and each corporation playsa different sport. When a corporation wins, it is due to the hard work of thousands of people;each of them creates value for the firm. The complexity of recognizing value created by theemployees in a large corporation is greatly magnified, and therefore more difficult to assign aspecific amount of created value to each contributing employee. For example, if a large softwarecorporation successfully launches a new product, should the CEO get credit for the increase inshareholder wealth? Do the increased profits for the company justify the million dollar bonusesthe CEO receives? What about the value created by the other 10,000 employees? The new product was likely successful for a number of reasons: The talented software engineers laboreddiligently to produce the product. The marketing department worked tirelessly to effectivelyadvertise. Salesmen relentlessly sought out new customers. These employees also deservecredit for the value they create. Employees in fact, are often rewarded for such value creatingefforts in the form of stock options. It seems then, that the CEO is being awarded stock optionsfor the same value creation that the lower level employees are being compensated for. In the baseball example, other players (such as pitchers) are recognized for the value they create and2
 
are compensated accordingly with high salaries. The baseball franchise knows that Barry is notthe only one who creates value. Obviously, a company should recognize that a CEO does notcreate all the value for a firm, yet companies often pay their CEO as if he does just that. ManyCEOs also get paid large amounts even when the company performs poorly. A recent WallStreet Journal article by Joseph Hallinan illustrates such an instance. At Conseco, the previousCEO was given a $13.5 million severance package. The CEO before him was given a $45million signing bonus. Conseco however, lost billions during the tenures of these two CEOs(Hallinan, 2004). Clearly, these executives were not paid for any value created. If this is thecase, then the forces of an efficient market should react to such a discrepancy betweencompensation and value creation, which leads to the next justification.
Justification #2:
There market for executives is efficient and fair.
A highly paid CEO will likely argue that his compensation is subject to market forces. If a CEO is overpaid or underperforming, then the market for executives can provide the companywith another qualified person to do the job. This argument however, assumes that the market for executives is both efficient and fair. The market for executives is not efficient however, becausecompanies face high transaction costs associated with finding and employing a new CEO. For example, the switching costs associated with firing an old CEO and hiring a new CEO aretremendous. Also, a CEO who is fired is often entitled to a large severance package as part of his contract. Getting an unsuccessful CEO to walk quietly is not easy, especially if that CEO hasstrong relationships with board members. Finding the new CEO can be costly as well. Acompany may have to spend millions of dollars searching for the right CEO to manage thecompany. The uncertainty associated with a new CEO can create market apprehension. Manycompanies face volatility in their stock prices due to this uncertainty. This volatility can hurt the3
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